Juno Lawyer Amanda Horgan breaks down four things in-house legal teams should consider when advising their chief executive or board, from liability caps and carve-outs to drafting and insurance.
Understanding how liability and indemnity clauses work, and interact, is essential for any chief executive and board signing commercial contracts on behalf of their organisation. Getting these provisions wrong can expose the organisation to losses well beyond what was contemplated, and beyond what insurance will cover.
What your CEO and board need to know about liabilities and indemnities
1. What is the difference between contract liability and an indemnity?
Liability is the legal responsibility taken on when a contract is entered into. If a party to a contract fails to meet their contractual obligations, that party becomes liable for the resulting “damage” or financial consequences for the other party (in very simplified terms).
An indemnity is a legally binding promise where one party agrees to cover the financial losses or legal liabilities of another party that result from an agreed trigger event.
While liability and indemnities may seem to be “same, same but different” at first glance, there are important differences.
- A liability clause is relevant in the event of a claim of breach of contract, which requires the claiming party to prove contractual breach. The damages for the breach are limited to those that are “reasonably foreseeable”, the claiming party must actively take steps to reduce or “mitigate” losses and contracts generally contain a cap on liability and exclusions from liability (more on this below).
- For an indemnity, the claiming party need not prove contractual breach, rather just that the triggering event occurred; this is where the drafting of the indemnity clause becomes important. The damages able to be claimed may be broad and, for example, extend to legal fees and other losses that would not otherwise be forseeable (again depending on how the clause is drafted). Generally, the claiming party is not required to mitigate losses.
Key takeaway: An indemnity is generally more favourable for the claiming party than liability for breach of contract. Likewise, a supplier will want to avoid granting an indemnity, if possible.
2. Does the contract have a reasonable liability cap and what are the carve outs?
Liability caps can be agreed that apply to both contract liability and an indemnity. There are a number of considerations here, and ultimately it depends on the type of contract being entertained, “industry norms” and company policy.
Ultimately, the chief executive and board (if any) will want to know that the liability cap is reasonable, that risk is shared fairly between the parties, all things considered, and that liability is covered by insurance (more on this below).
Common methodologies for arriving at a reasonable liability cap include:
- linking the cap to fees paid or payable under the contract either during the term of the contract or over a calendar year;
- a multiple of fees paid or payable during the term or over a calendar year; and
- a fixed amount informed by the nature of the goods/services and insurance coverage.
A liability cap is not the end of the story though; it is common for contracts to include items to which the liability cap does not apply.
Examples include liability for injury or death (which is less relevant in New Zealand because of ACC), breach of confidentiality, intellectual property breach and data breaches, and wilful default and fraud. It is also common for these exclusions to provide that liability extends to consequential losses (the ripple effect) in addition to direct losses.
Other commonly seen terms include a liability cap for some items, but a super cap for other items. This can be a valuable tool to achieve alignment on liability caps during negotiations.
Key takeaway: Take a step back, consider where the risk on material matters should lie and ensure the contractual provisions align with that.
3. Drafting Drafting Drafting
The considerations above can be rendered useless by contract liability and indemnity clause drafting, as in the end, it often comes down to contractual interpretation. Reciprocity is an important consideration as suppliers (for example) will often narrow the indemnity to be offered by them but broaden the indemnity to be offered by the client.
One practice that is becoming more and more common is to limit liability under an indemnity to the amount of a final Court judgment on the matter. Personally, I am not a fan of this approach as it cuts across the basic premise of an indemnity – that only the triggering event must be proven, not the amount of contractual damages - however, it can be a useful tool to get a negotiation over the line.
Key takeaway: It doesn’t matter how you think the clauses work, it matters what the clauses say.
4. Insurance
Insurance should not be glossed over when advising a chief executive and/or board. In my experience it is not well known that insurance policies only cover liabilities a business would face under common law.
This means that any obligations or indemnities voluntarily assumed as part of a negotiation that go beyond standard legal liability are generally not covered by insurance. Examples include liquidated damages, warranties and guarantees and assuming a third party’s liability.
Key takeaway: Engage with your organisation’s insurance brokers to understand what is and what is not covered and, if necessary, on particular contracts and relevant clauses.
Ngā mihi nui to Juno Lawyer Amanda Horgan for sharing her experience and practical guidance with the in-house legal community, bringing a commercially minded approach to translating legal issues into clear, practical advice for the wider business.
Want to go deep on liabilities and indemnities? You can also watch our 2023 Juno Learning webinar on liabilities and indemnities, and its companion Juno Learning summary
If you’d like to know more about our team or how Juno supports in-house legal teams, you’re welcome to get in touch.
Or explore the Juno Counsel archive for more stories and perspectives from Aotearoa’s in-house legal community.